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Understanding Financial Statements In 5 Easy Steps

1. Why is it important to understand financial statements?

Financial statements provide information about the economic performance of a company. The purpose is to show how investors’ money has been used in trying to obtain profits and growth, in both, the short and long term. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, revenues, expenses, income and equity are directly related to an organization’s economic success.

2. How can financial statements help me decide if I should buy shares from a company or not?

Prospective investors use financial statements to analyse the viability in terms of risk, profitability and growth of investing in a company. Financial analyses are often prepared by professionals (financial analysts), thus providing the basis for making investment decisions on whether you should buy shares from a company or not. A financially educated investor should be able to carry out his/her own analysis to decide whether or not the investment is worthy in terms of generating cash, profit and equity value. This applies to small and medium enterprises.

3. What is the difference between balance sheet, income statement and cash flow statement? What do all those sections say about a company?

Balance Sheet: It is used in accounting to clearly understand the state of a company’s finances, particularly, how assets have been financed, what obligations are pending to be paid to suppliers and financiers, how cash has increased or decreased during the period under review, and how equity has been generated or decreased.

Income Statement or Profit and Loss Account: it measures the difference between revenues (increase in assets) and expenses (decrease in assets) that has occurred during an accounting period. When revenues are higher than expenses then there is a profit. The contrary implies a loss. Profit increases equity whereas a loss diminishes it.

Statement of Cash Flows: It describes how the business has generated and used cash during the accounting period.

Statement of Changes in Equity: It shows the effect of certain transactions on the value of equity.

4. What are the measures that can help me assess a company’s financial health?

Those would be financial ratios. A financial ratio (or accounting ratio) is a mathematical expression, a fraction of two selected values taken from the financial statements. Financial Ratios are main tools to analyse the financial strength of a firm. The information contained in the Income Statement and the Balance Sheet is essential to obtain financial ratios. Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis.

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LIQUIDITY Ratios measure the availability of cash to pay obligations to creditors and accrued expenses.

Current Ratio – Shows the extent to which a firm can meet its short-term obligations.

Quick Ratio – Indicates the extent to which a firm can meet its short-term obligations without relying upon the sale of its inventory

LEVERAGE Ratios measure the firm’s ability to repay long-term debt.

Debt-to-Asset Ratio – The percent of funds provided by creditors in relation to capital employed

Debt-to-Equity Ratio – Indicates the proportion between external debt and equity in a firm’s long-term capital structure.

PROFITABILITY Ratios measure the efficiency of the use of assets, generation of revenue and control of expenses to obtain an acceptable rate of return (profit/capital).

Gross Profit Margins Ratio – Indicates total margin available to cover operating expenses and yield a profit.

Return on Total Assets Ratio – Shows total return to assets investment.

Return on Initial Investment/Capital (ROIC) Ratio – Indicates how the initial investment has performed during a given period. It is obtained dividing equity in the period by initially invested capital when launching the firm.

Return on Equity (ROE) Ratio – Measures management ability in optimizing equity. It is done on a period by period basis comparing profit or loss with equity.

5. Where should I start if I want to write financial statements for my small company? Should it be done by a professional?

A financially educated entrepreneur should be able to prepare the financial statements for his/her own small company. There are self-paced financial education courses available on the web, which provide the needed knowledge and skills to master this discipline.
Usually financial statements are prepared using standard accounting software off the shelf, for which training in financial accounting is required to understand accounting procedures to operate the software and the interpretation and analysis of financial statements.

Posted in: Business matters

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